Question

OceanGate sells external hard drives for $260 each. Its total fixed costs are $30 million, and its variable costs per unit are $210. The corporate tax rate is 30%. If the economy is strong, the firm will sell 2 million drives, but if there is a recession, it will sell only half as many.
a.
What is the firms' degree of operating leverage (defined as the ratio of the percent change in EBIT to the percent change in sales)?



Degree of operating leverage


b.
If the economy enters a recession, what will be the firm’s after-tax profit? (Enter your answer in millions.)



After-tax profit $ million

Answer 1

Answer:

a. in order to calculate this we must assume that the economy entered a recession:

degree of operating leverage = [($20 - $70)/$70] / [($260 - $520)/$520] = -0.7143 / -0.5 = 1.43

b. $14 million

Explanation:

strong economy:

total sales $520 million

variable costs $420 million

gross profit $100 million

fixed costs $30 million

EBIT $70 million

income taxes $21 million

net income $49 million

weak economy:

total sales $260 million

variable costs $210 million

gross profit $50 million

fixed costs $30 million

EBIT $20 million

income taxes $6 million

net income $14 million